So should we worry that this financial crisis and its fiscal costs will eventually lead to higher inflation? The answer to this complex question: likely not.
First, the massive injection of liquidity in the financial system--literally trillions of dollars in the last few months--is not inflationary, as it accommodates the demand for liquidity that the current financial crisis and investors' panic have triggered. Thus, once the panic recedes and this excess demand for liquidity shrinks, central banks can and will mop up all this excess liquidity.
Second, the fiscal costs of bailing out financial institutions would eventually lead to inflation if the increased budget deficits associated with this bailout were to be monetized, as opposed to financed with a larger stock of public debt. As long as such deficits are financed with debt--rather than by the printing presses--such fiscal costs will not be inflationary, as taxes will have to be increased over the next few decades and/or government spending reduced to service this large increase in the stock of public debt.
Third, to the question raised earlier: Wouldn't central banks be tempted to monetize these fiscal costs--rather than allow a mushrooming of public debt--and thus wipe out with inflation these fiscal costs of bailing out lenders/investors and borrowers? Not likely in my view. Even a relatively dovish Bernanke Fed cannot afford to let the inflation-expectations genie out of the bottle via a monetization of the fiscal bailout costs. It cannot afford to do that because a rise in inflation expectations will eventually force a nasty and severely recessionary Volcker-style monetary-policy tightening to get the genie back into its bottle.
As for the counter-argument, here is an article by Steve Saville that I quoted in a previous post:
By way of further explanation, during the early part of a major upward trend in money-supply growth it will typically be the case that inflation is not widely perceived as a problem. Actually, it's quite likely that deflation will be seen as the bigger threat. This is the situation that we often refer to as a "deflation scare" -- rising money-supply growth (inflation) combined with rising fear of deflation, with the fear of deflation being fanned by falling commodity and equity prices.
Jeffrey A. Miller, Ph.D. at A Dash of Insight has an insightful take on the history of the crisis, and potential impact of government intervention. I am always interested to read astute observations as to what has actually happened, since there is such a broad range of opinion on the subject.
First, and very importantly, we allowed various private market actions and government facilitation to create a dangerous and highly leveraged environment. There are plenty of people analyzing this, and we are as well.
Second, the needed process of deleveraging took place at WARP speed. There was no one at the helm. Existing structures were pro-cyclical, making the changes occur more rapidly rather than dampening effects, and giving everyone a chance to adjust.
Third, those seeing the money sought the losers in the Credit Default Swap Market. Option players purchased put options that could profit only if the company went out of business in a week or two. When this strategy worked in the Bear Stearns case, many observed the pattern and piled on. There are now investigations about this pattern of trading.
Fourth, distress sales at one company became the new standard, via mark-to-market accounting, for other companies. The market bulls eye moved from one victim to another.
Fifth, the government, far too slow to recognize the problem and to act in advance, was forced into a reactive mode. The decisions about which companies to save seemed completely arbitrary. The decisions about whether to punish common shareholders, preferred shareholders, or bondholders were equally arbitrary.
Speaking of credit default swaps, AIG is burning through cash:
The American International Group is rapidly running through $123 billion in emergency lending provided by the Federal Reserve, raising questions about how a company claiming to be solvent in September could have developed such a big hole by October. Some analysts say at least part of the shortfall must have been there all along, hidden by irregular accounting.
"You don't just suddenly lose $120 billion overnight," said Donn Vickrey of Gradient Analytics, an independent securities research firm in Scottsdale, Arizona.
...These accounting questions are of interest not only because U.S. taxpayers are footing the bill at AIG but also because the post-mortems may point to a fundamental flaw in the Fed bailout: the money is buoying an insurer — and its trading partners — whose cash needs could easily exceed the existing government backstop if the housing sector continues to deteriorate.
Market bottom-callers should carefully consider the AIG situation. AIG was bailed out primarily because of its $447 billion in CDS, much of which is at risk. With GDP decreasing, unemployment increasing, and consumer confidence plummeting, housing prices will continue to fall. The synergies of this crisis are still very bad.
Shah Gilani provides an overview in The Credit Crisis and the Real Story Behind the Collapse of AIG. Highly recommended.
Because there are so many different individual CDO securities, and because there are so many credit default swaps on so many of these CDOs, and so many swaps on individually referenced entity debts and loans, the only way to value them in a portfolio is by indexing.
...Here’s the problem: If you own a portfolio of CDOs, and the only way to value them (or, at least, to develop a valuation that others are reasonably certain to respect), is by looking at them through the prism of an index of credit default swaps on them, you’re at the mercy of the index. Your portfolio, your securities may not be so bad, but you may not really know based on mortgage-duration analysis and foreclosure events that you can’t calculate. So you value, or mark-to-market, against the closest index.
Here’s the rub. What if other speculators are selling short – that is, betting in anticipation of that index going down? What if large portfolio-hedgers are selling short the index to hedge the portfolio they can’t sell because no one will buy it – because no one knows what it’s worth?
...Credit default swaps are creating a downward spiral in the capital markets, driving up the cost of capital, and squeezing out all manner of borrowers. And these speculative bets run amok are undermining all U.S. Federal Reserve and U.S. Treasury Department efforts to “liquefy” the system. If this keeps up, the credit default market could sink the U.S. economy into a recession/depression that will make the Great Depression look like a day at the beach.
Roger Ehrenberg offers Some Observations on Quantitative Trading:
Returns can either be bolstered one of three ways, either by (1) introducing better returning, but riskier and more capital intensive longer-dated strategies, (2) increasing leverage, or (3) extracting value from completely new and untested data sets. With many quant funds getting killed in 2007 due to leverage and crowded trades, I find it hard to believe that they will choose option 2. But given current (and expected) high levels of volatility, will quants (and their risk managers) have the stomach for longer-dated strategies? Maybe more calories will be spent on alternative data and approaches, trying to find new ways to capture edge in a busy landscape.
It is a confusing time to be running money, especially using quantitative approaches, where recent events create statistical outcomes so out of step with the past that historical analysis is of limited value. It is not a question of analyzing and managing a handful of stocks in a long/short portfolio, but of coming up with models and frameworks that can be applied to hundreds and thousands of names, all at once, in real-time. So where do you hang your hat? What are the new paradigms that will enable market-beating quants to emerge? Is it new paradigms or new data sets that will lead quants forward to better times? I would bet that it will be a combination of the two. And if history is any guide, a handful of quant funds will emerge from the ashes as market-beaters for years to come.
Lastly, Calculated Risk reports: Almost Half of Nevada Homeowners Underwater.
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1 comments:
Groov, great summary and thanks for all the links
Fab
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